Cadena De Valor

So-called “electronic front running” involves a situation in which an HFT, before others in the market, learns of a transaction that has occurred at one exchange and alters its quotes on other exchanges given the possibility that similar orders may still be in transit heading toward other exchanges. The HFT races ahead of these orders still on their way to the other exchanges and, before they arrive at their destinations, changes its quotes on these other exchanges.82

Electronic front running has been harshly criticized. For example, Charlie Munger, vice chairman of Berkshire Hathaway, has objected that high-frequency trading is “legalized front-running[,] . . . and it should never have been able to reach the size that it did.”83 Similarly, New York Attorney General Eric Schneiderman has complained that “[w]hen blinding speed is coupled with early access to data, it gives small groups of traders the power to manipulate market movements in their own favor before anyone else knows what’s happening.”84

Flash Boys, published after these comments, makes electronic front running its principal focus.85 Even more

82. See supra Part I.C.1. For fascinating empirical evidence suggesting that electronic front running occurs, see Vincent van Kervel, Liquidity: What You See Is What You Get? 2–6 (May 2012) (unpublished Ph.D. thesis, Tilburg University), http://www.rsm.nl/fileadmin/home/ Department_of_Finance__VG5_/LQ5/VanKervel.pdf [http://perma.cc/RBX2-P9QP] (modeling and gathering empirical evidence that transactions on venues are followed by limit order cancellations on competing venues).

83. Sam Mamudi, Charlie Munger: HFT is Legalized Front-Running, BARRON’S:STOCKS TO WATCH (May 3, 2013, 1:25 PM), http://blogs.barrons.com/stockstowatchtoday/2013/05/03/ charlie-munger-hft-is-legalized-front-running [http://perma.cc/NS8R-V7QN].

84. Linette Lopez, New York’s Attorney General Has Declared War on Cheating High- Frequency Traders, BUS.INSIDER (Sept. 24, 2013, 2:41 PM), http://www.businessinsider.com/ schneiderman-targets-hft-front-running-2013-9 [http://perma.cc/EX85-TCH3].

85. See, e.g., LEWIS,supra note 2,at 108, 126, 172. Since the publication of the book in the spring of 2014, a host of other commentators have chimed in with criticism equating electronic front running with traditional illegal front running. See, e.g., Ellen Brown, Computerized Front Running: Another Goldman-Dominated Fraud, HUFFINGTON POST:THE BLOG (June 26, 2010, 5:12 AM), http://www.huffingtonpost.com/ellen-brown/computerized-front-runnin_b_548148. html [http://perma.cc/X379-8R3P] (stating that electronic front running contributes to “the manipulation of markets for economic and political ends”); Gene Marcial, High-Frequency

recently, a prominent class-action suit was filed against all of the nation’s exchanges that, in support of its claim of fraud, includes allegations that the exchanges cooperated with HFTs in facilitating electronic front running.86

Substantively, all these criticisms focus on the fact that when an HFT engages in an act of electronic front running, the HFT can be expected to be better off and some other trader involved worse off. It should be noted at the outset, however, that the HFT practice labeled as “electronic front running” is distinctly different from the kind of behavior that has traditionally been termed “front running.” Traditional front running, which is clearly illegal, relates to a situation involving a customer giving her broker an order to handle. Then the broker, which has a legal duty to its customer not to use knowledge of its customer’s order to its own advantage, breaches this duty by engaging in a trade on its own behalf that executes ahead of the customer’s order.87

In contrast, when an HFT engages in the practice labeled as “electronic front running,” it has no preexisting relationship with the trader placing the order that the HFT detects and so no relationship between the two could give rise to a duty on the part of the HFT akin to what a broker owes its customer. The matter of whether rules should prevent HFTs from engaging in this practice is of course an appropriate issue for policy analysis, as is

Trading Mainly Hurts the Traders and Short-Term Investors, FORBES (Apr. 2, 2014, 4:06 PM), http://www.forbes.com/sites/genemarcial/2014/04/02/high-frequency-trading-mainly-hurts-the- traders-and-short-term-investors [http://perma.cc/4DTH-SN7W] (stating that “front-running on Wall Street, which is what high-frequency trading is all about and what it really intends to be, is old news,” and arguing that only the speed with which HFTs front run other investors is new).

86. Amended Complaint at 26, City of Providence v. BATS Global Mkts., Inc., No. 14-cv- 2811-SMF (S.D.N.Y. Sept. 2, 2014).

87. Traditional front running is prohibited under the common law, federal law, and industry self-regulatory standards. See Opper v. Hancock Sec. Corp., 250 F. Supp. 668, 676 (S.D.N.Y. 1966), aff’d, 367 F.2d 157 (2d Cir. 1966) (holding front running to be illegal under principles of agency and federal law). The SEC prosecutes front running as a violation of Section 10(b) of the Exchange Act and Rule 10b-(5). See, e.g., Complaint at 13, SEC v. Bergin, 2015 WL 4275509 (N.D. Tex. May 23, 2013) (No. 3:13-cv-1940), 2013 WL 2400793 (charging trader for front running clients under Section 10(b)); see also Concept Release on Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 3609 (proposed Jan. 14, 2010) (to be codified at 17 C.F.R. pt. 242) (discussing the illegality of front running). FINRA Rule 5270(a) prohibits trading in a security if an individual has “material, non-public market information concerning [a customer’s] imminent block transaction in that security,” until that block transaction has become public. FINRA Rules, FIN.INDUS.REGULATORY AUTH., at Rule 5270 [hereinafter FINRA Rules], http://finra.complinet.com/en/display/display_viewall.html? rbid=2403&element_id=607&record_id=609&filtered_tag= [http://perma.cc/78SE-RWUZ] (last amended Sept. 3, 2013).

being undertaken here. It is important to note, however, that the practice involves no breach of duty or mutually-agreed-upon terms between contracting parties, nor does it involve any obvious breach by HFTs of the federal anti-fraud laws.

1. An example. We will examine the practice of electronic front running through use of an example. For simplicity of exposition, just one HFT, Lightning, and two exchanges, BATS Y and NASDAQ, are involved. Lightning has co-location facilities at the respective locations of the BATS Y and NASDAQ matching engines. A high- speed fiber-optic cable connects these co-location facilities with each other.88

An actively managed institutional investor, Smartmoney, decides that Amgen’s future cash flows are going to be greater than its current price suggests. The NBO is $148.00, with 10,000 shares being offered at this price on BATS Y and 35,000 shares at this price on NASDAQ. Smartmoney decides to buy a substantial block of Amgen stock and sends a 10,000 share market buy order to BATS Y and a 35,000 share market buy order to NYSE.89 The 35,000 shares offered at $148.00 on NASDAQ are all from sell limit orders posted by Lightning.

The order sent to BATS Y arrives at its destination first and executes. Lightning’s co-location facility there learns of the transaction very quickly. An algorithm infers from this information that an informed trader might be looking to buy a large number of Amgen shares and thus may have sent buy orders to other exchanges as well. Because of Lightning’s ultra-high-speed connection, it has the ability to send a message from its BATS Y co-location facility to its co-location facility at NASDAQ, which in turn has the ability to cancel Lightning’s 35,000 share $148.00 limit sell order posted on NASDAQ. All this can happen so fast that the cancellation would occur before the arrival there of Smartmoney’s market buy order. If

88. See supra Parts I.A and I.C for a discussion of exchange matching engines and HFT co- location facilities.

89. This example fleshes out the story by Michael Lewis of how electronic front running could occur with Amgen stock in such a situation. LEWIS,supra note 2, at 33–34. Lewis asserts that the HFT could profit at the expense of others by cancelling its quotes on another exchange, but he does not discuss exactly why it would be profitable for the HFT to do so. Nor does he analyze how the quotes initially available might be different if the practice of electronic front running were eliminated. The discussion that follows fills in these holes.

Lightning does cancel in this fashion, it has engaged in electronic front running.

Why might Lightning wish to cancel its sell limit order on NASDAQ? One possibility is that given its inference that a large market buy order is likely soon to arrive at NASDAQ, Lightning wishes to submit, in place of its cancelled order, a new sell limit order for the same number of shares at a higher price, say at $148.02. If Lightning does so and Smartmoney’s buy order executes against this new higher quote, the HFT will be better off, and Smartmoney worse off, by $.02 per share.

Note though, that the HFT will be able to improve its position in this way only if the NASDAQ limit order book has room so that the $148.02 offer price is still more attractive to potential buyers than any other offers with respect to Amgen already posted on NASDAQ. Suppose, for example, that prior to Lightning’s cancellation, the next best offer on NASDAQ was 15,000 shares at $148.01 and the best offer after that was 20,000 shares at $148.02. The price- and time- priority rules would mean that Smartmoney’s buy order would execute against these other two standing offers, not against any new $148.02 offer by Lightning.

This cautionary note, though, hides a more critical point: Lightning may wish to cancel its $148.00 sell limit order even if in fact the book contains no room to improve its position by selling to Smartmoney at a higher price. Recall that to survive in a competitive market, a market maker like Lightning must set its quotes aggressively enough to attract business, but not so aggressively that the money it makes by buying from, and selling to, uninformed traders is less than what it loses by engaging in such transactions with informed traders. At the time it posted its sell limit order, Lightning calculated $148.00 as the optimal price for an offer of 35,000 shares, based on what it knew then about the likelihood of the existence of positive private information. Now, however, Lightning knows something more: a large buy order has transacted on BATS Y. This will cause Lightning to revise upward its assessment of the likelihood that private information suggests that the value of a security is higher than the market previously thought. The upward revision is very possibly great enough that $148.00 is no longer the optimal price at which to offer to sell shares. In that case, Lightning will be better off cancelling its $148.00 limit offer on NASDAQ.

2. Wealth-transfer considerations. To see the distributive effects of electronic front running, we need to consider how the world would differ if the practice were eliminated. As a first cut for this discussion of the practice’s wealth effects, and for the discussion below of its efficiency effects, we will make the assumption, later relaxed, that only three kinds of market participants exist: HFTs, informed traders who trade on the basis of fundamental value information, and uninformed traders.90

a. Electronic front running narrows spreads. As the analysis of the example makes clear, the practice of electronic front running by HFTs makes orders by large purchasers and sellers somewhat less anonymous in the sense that the practice allows HFTs to better detect the possibility that informed market orders are headed for their limit orders. If HFTs did not have the ability to learn these things and alter their standing limit orders accordingly, they would know that a larger percentage of the trades that will execute against their limit orders will come from informed traders. The primary cost of being a liquidity supplier—the losses incurred from dealing with informed traders— would therefore go up. Accordingly, HFTs would increase their initially posted spreads to compensate.

Going back to our example, if Lightning were not able to electronically front run, it might have initially posted its limit sell order for 35,000 shares at $148.01 instead of $148.00. For the same reasons, it would also have a lower bid. So if, with electronic front running being allowed, its bid would have been $147.96, without the practice its bid might instead have been $147.95.

b. Electronic front running helps uninformed investors and hurts informed investors. If electronic front running were eliminated, uninformed traders and informed traders will each suffer from the resulting larger spreads—the higher offers and lower bids—because for both it will be more expensive to trade. For uninformed traders, that is the end of the story. Informed traders, however, would get a more-than-compensating benefit.

To see why, the starting point again is the fact that the elimination of electronic front running would make it more difficult

90. See supra Part III.A for a discussion of the different types of private information. We will revisit this discussion later with a more nuanced analysis that focuses on the fortunes of each of the three kinds of informed traders: fundamental value information traders, announcement traders, and inside-information traders. See infra Part V.A.4.

for HFTs to detect indications of possible informed orders, and so more informed trades would execute against their quotes. Trading is a zero-sum game. Thus, if HFTs did not increase their spreads in response to the end of the practice, the gains enjoyed by informed investors would just equal the increased losses suffered by HFTs. In fact, however, if electronic front running is eliminated, then HFTs will increase their spreads. They will do so by an amount just sufficient to cover what these losses would otherwise be.91 This is because, as we learned in Part III, the economic pressures on HFTs operating in a competitive market require them to set their spreads at a level such that they just break even.

The increased spreads will be borne by all traders, informed and uninformed alike, because the HFTs cannot condition their exchange- posted limit orders on the identity of the person who sends the market orders against which their limit orders execute.92 This means informed traders come out ahead: the gains they would have enjoyed without the increase in spreads are not fully dissipated by the extra they must pay because the spreads in fact are increased. The rest of what HFTs need to break even comes from uninformed traders, who must pay the increased spread too.

In sum, without electronic front running, HFTs would find it harder to detect indications of possible trading on private information and as a result would increase their spreads. Informed traders would get all of the gains from being better able to hide the informed nature of their trades. But they pay, through the increased spreads, only part of the added costs incurred by HFTs as a result of entering into more losing transactions. The rest of these added costs are borne by uninformed investors, who receive no such benefit. So, electronic

91. For reasons of expository simplicity, this statement assumes that the increase in spreads would not decrease the volume of trading. Therefore, it is assumed that the increase in the absolute number of HFT trades with informed traders that would occur from the elimination of electronic front running would be the same with the increase in spreads as without. In fact, an increase in spreads makes trading more costly, suggesting that the volume would be lower with the increase in spreads than without it. This simplification does not alter the basic logic of the analysis in the text, however.

92. Regulation NMS Rule 610(a) precludes exchanges from restricting access to trading on their facilities. See 15 U.S.C. § 78f(b)(2) (2012) (providing that “the rules of [a registered] exchange [must] provide that any registered broker or dealer . . . may become a member of such exchange”); 17 C.F.R. § 242.610(a) (2015) (prohibiting “national securities exchange[s] [from] . . . prevent[ing] or inhibit[ing] any person from obtaining efficient access” to trading against the buy and sell quotes posted on exchanges).

front running benefits uninformed investors and harms informed ones.

c. The ultimate incidence of electronic front running. Electronic front running has been regularly attacked as harming “ordinary investors.”93 Our analysis, however, suggests that this attack is unmerited. To start, consider retail investors, the paradigmatic ordinary investors. Retail investors generally lack any significant private information and hence are properly assumed to be uninformed. Uninformed investors, as we have just seen, are helped, not hurt, by electronic front running.

Most of the persons whose money is invested in index-based mutual funds and pension funds would also presumably count as ordinary investors. These entities too, by definition, are uninformed traders: their purchases and sales are not prompted by any kind of private information. Rather they purchase all the stocks in the index when they receive a net inflow of investor funds and sell all stocks in the index when the volume of investor redemptions is sufficient to result in a net outflow of funds. Again, electronic front running, by narrowing spreads and reducing the cost of trading, helps, not hurts, these funds and derivatively their ordinary investors.

What, though, about people who invest in managed mutual or pension funds? They too are presumably mostly ordinary persons.94

These entities do fundamental value research and thus have the potential of being informed investors. The analysis above suggests that electronic front running hurts informed investors. Though these funds can be expected to enjoy gains from the elimination of electronic front running, these gains might well not be passed on to the ordinary people who invest in them. The investment industry and those who work in it each appear to operate in fairly competitive markets. To the extent that these markets are in fact competitive, much of whatever above-market returns are generated by these institutions’ informed trading will be captured in the form of higher

93. See, e.g., LEWIS,supra note 2, at 104; see also Amended Complaint at 93–95, City of Providence v. BATS Global Mkts., Inc., No. 14-cv-2811-SMF (S.D.N.Y. Sept. 2, 2014).

94. See INV.CO.INST.,2013INVESTMENT COMPANY FACT BOOK 90 (53d ed. 2013), http:// www.ici.org/pdf/2013_factbook.pdf [http://perma.cc/KWT6-JAN4] (stating that mutual funds are primarily owned by individual investors). Indeed, it appears to be these particular ordinary investors that Michael Lewis has in mind when arguing that electronic front running takes money from ordinary folks on Main Street and gives it to HFTs. See LEWIS,supra note 2, at 81, 102, 108, 172.

fees or salaries for the professionals who make the actual investment decisions.95 This suggests that any gains in these entities’ trading returns that might result from the elimination of electronic front running are likely to go primarily to increase the fees and salaries of